New Bank Regulations Could Drive Global Recession

Just as you thought the mess in Europe could not get any worse; just as you thought the emerging global recession could not get any worse; just as you thought the U.S. deficit could not do more harm… a new report from Fitch Ratings comes out and throws another wrench in the machinery.

This is a somewhat complex story, but hang in there. It’s all tied together at the end, from something called the Basel III bank equity rules to the Greek crisis to the U.S. deficit.

Let’s start with the so called Basel III rules, which are new global standards to guarantee bank solvency. In a nutshell, Basel III forces banks to reduce their holdings of risky assets and increase their holdings of “common equity”. This means, of course, that banks will run away from assets that are risky or have a rising risk to them. Historically, an investor who wants to lower his risk exposure has put government bonds at the top of his wish list; with the turbulence around the Greek euro membership spilling over on other European countries, this historic truth is being put on its head. The Basel III rules could, in fact, add insult to injury when Greece and other troubled EU member states try to stabilize their government finances.

Fitch Ratings estimates that, as of end-December 2011, the 29 global systemically important financial institutions (G-SIFI), which as a group represent $47 trillion in total assets, might need to raise roughly $566 billion in common equity in order to satisfy new Basel III capital rules, which represents a 23% increase relative to these institutions’ aggregate common equity of $2.5 trillion. Although Basel III will not be fully implemented until end-2018, banks face both market and supervisory pressures to meet these targets earlier. Banks will likely pursue a mix of strategies to address these shortfalls, including retention of future earnings, equity issuance, and reducing risk-weighted assets … Absent additional equity issuance, the median G-SIFI would be able to meet this shortfall with three years of retained earnings, which might constrain dividend payouts and share buybacks.

Common equity is a measurement of a bank’s assets that essentially concentrates on what you can “touch”, in the form of tangible assets, including cash and actual shareholder investments. The point with Basel III is to force banks to think about their assets in a new, financially more conservative way. It sounds like a good idea, but it has three important consequences.

To begin with, the last two major bank bailouts – the one in the early ’90s and the one now during the Great Recession – have taught banks that there is no more tangible asset than taxpayers’ money. Governments have: a) encouraged banks to supply mortgage loans to people with sub-par credit, b) borrowed recklessly from the same banks by selling them treasury bonds to fund budget deficits, and c) save said banks with tax-paid bailouts when the sub-par mortgage bubble burst and, almost simultaneously, governments started having acute problems paying for their loans. As a result, two generations of bank managers have learned that taxpayers will always be there for them. What credibility do these bank managers place in these new rules? How likely are they to comply with them when they go into full effect in 2019?

Secondly, and more importantly for Europe’s troubled welfare states, the required half-trillion dollar increase in common equity holdings will more than likely exclude treasury bonds from several European countries. The reason is a combination of two factors: the mess that these welfare states have created by over-spending for many years and the fact that we are heading in to a global recession. Even though the Basel III rules do not go into effect until several years down the road, it is no small task to raise that kind of money, especially since we are now on the brink of a global recession. As we all know, a recession comes with sluggish or no growth, more business closings and higher unemployment. All this means that more investments are at the risk of insolvency – and it is harder to find solid investments that will reduce a bank’s risk exposure.

The combination of a deepening recession, euro-zone instability and already-troubled treasury bonds all across the southern rim of Europe is a powerful challenge for the 29 financial institutions mentioned in the Fitch report. Back in 2010 some analysts thought that Basel III will increase demand for government bonds, but that is no longer the case. The enormous crisis in Greece has re-written the rules for government bond risk, especially in Europe. Spanish 10-year bonds, e.g., are currently trading at almost twice the interest they were at in 2005. The rate is rising steadily and closing in on 6.5 percent. This is a long-term trend that has lasted for more than a year now and is unlikely to break over the next year. A Greek currency secession would put Spain on the spot, with speculators weighing the likelihood that they be the next to exit the euro.

The European Central Bank, in turn, will fight tooth and nail over the next year to keep its currency union stable. In the meantime, investors will anxiously look on and hold on to their assets, all in order to comply with the well-known rule that in times of uncertainty, he who hesitates is saved to make a decision another day.

There could be positive effects for the United States in all this. If Congress gets its act together and first reins in, then starts permanently reducing its debt, then U.S. Treasury bonds will become a very safe haven for global financial institutions under Basel III. If on the other hand the United States continues down the current path of complete deficit delusion, we will contribute to forcing the banks into an ever narrower market of reliable equity. This will drive up the cost for the banks, which they in turn will pass on to their customers. As a result, global growth will suffer. The OECD makes this prediction even without taking into account the deteriorating reliability of government bonds:

The estimated medium-term impact of Basel III implementation on GDP growth is in the range of −0.05 to −0.15 percentage point per annum. Economic output is mainly affected by an increase in bank lending spreads as banks pass a rise in bank funding costs, due to higher capital requirements, to their customers. To meet the capital requirements effective in 2015 (4.5% for the common equity ratio, 6% for the Tier 1 capital ratio), banks are estimated to increase their lending spreads on average by about 15 basis points. The capital requirements effective as of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio) could increase bank lending spreads by about 50 basis points. The estimated effects on GDP growth assume no active response from monetary policy. To the extent that monetary policy will no longer be constrained by the zero lower bound, the Basel III impact on economic output could be offset by a reduction (or delayed increase) in monetary policy rates by about 30 to 80 basis points.

In other words, an increase in the money supply. This is unlikely, at least over the next couple of years. The main reason is the turbulence in Europe, where the ECB now has enormous incentives to act tough on all fronts. A monetary policy that is perceived as lax will only add to the erosion of credibility in the euro zone, on top of the harm that Greece and other spendoholic governments have already inflicted.

It is therefore very likely that the Basel III requirements will lower global GDP growth and extend the current recession. Furthermore, it is likely that the deterioration of government bonds in Europe will squeeze the market that banks can use to meet the new capital requirements. This will aggravate the negative impact of Basel III on global GDP growth. Lastly,if the United States does not get its deficit under control, U.S. Treasury bonds could at some point fall off the list of desirable assets as the global financial institutions struggle to meet the new common equity goals.

What is so absurd about this whole thing is that virtually every aspect of it is created by government:

a) Government encouraged sub-prime mortgage lending;

b) Government borrowed relentlessly from the same banks that they had encouraged to enter the sub-prime market;

c) Government imposes Basel III rules as a consequence of government-driven lending; and

d) Government makes it harder and costlier for banks to meet Basel III rules by spending too much and messing up the reliability of government bonds.

Lastly, let’s not forget that government has encouraged banks to disregard common sense and good banking practice when it comes to solidity. Two major bailouts in two decades is more than enough to create an irresponsible risk-taking culture in banking. It remains to be seen how this history of tax-paid bailouts will interact with the Basel III requirements, but one thing is clear: if government had not been messing with the banking industry in the first place, none of this would ever have happened.